Fixed Income Options in Today’s Economy by John Milne, CEO JKMilne Asset Management

What Are The Fixed Income Options? More than ever: Process: Active or Passive Style: Sector Rotator or Duration Manager Decision Basis: Macro Economy drives Top-Down decisions? Or are decisions driven from the Bottom- Up by Micro Economic factors such as credit selection, issue structure and/or, optionality? There are increasingly more clearly defined style differences in Fixed Income that became evident in 2008.

What Are The Fixed Income Options? More than ever: continued There are more “sub asset” classes such as Investment Grade, High Yield, Non-US, Distressed…and more. Who do you want managing your money? Big Box, Boutique, Mutual Fund, ETF? Is the money managers ownership structure important? Independent? Critical Decisions…the “vehicle” used to acquire the above characteristics.

Why Are The Vehicles Important? Manager risk has become as great as investment risk.

The Fixed Income Opportunity Decision Tree Style Passive DOB 1979 Lehman Indexes Sampling Process Risk Benchmark Custom Generic Active Macro Economy i.e. Top Down DOB 2007 Sector Rotator Micro Economy i.e. Bottom Up DOB 1990 Duration Managed RIP 1990 Benchmark Custom Generic

There Are Long and Significant Secular Opportunities in Fixed Income Investment PeriodInvestor Risk Benchmark Hallmark (What Happened?) None “Low Interest Rates” largely a corporate bond market, no long bond exists 1960None “Nothing” 1960 the Tsy 10yr was 4.67%; % 1970None “Asleep at the Wheel” yr Tsy Yields 7.4%; 1979, 9.34%; 1980, 12.67% 1980Lehman Aggregate “The Mortgage Market Layup” As investors became risk managers they buy the market components in the indexes 1990Aggregate + “The Anything but Government Bonds Homerun” As the mantra is “buy corporates and Drexel will make me alpha.” Drexel closes Valentines Day Barclays Aggregate No leadership. Corporates hit all time wide spread October 2002, 2008 mortgages are volatile Source of yield data “Analytical Record of Yields & Yield Spreads” Saloman Brothers

What is a common active bond market index? Primarily U.S. investment-grade markets Liquid and does not include cash Barclays Capital Aggregate Index Source: Barclays Capital As of July 31, 2010

Barclays Aggregate Index Quality Exposure Source: Barclays Capital As of July 31, 2010

Barclays Corporate Bond Quality Exposure Source: Barclays Capital As of July 31, 2010

It’s Not Your Grandfathers Bond Market Corporates are increasingly correlated to the equity market The Total AAA Corporate Issuers are: –ADP –Microsoft –Johnson & Johnson The result is a market heavily reliant on credit decisions

Source: Bloomberg Historical Interest Rates 10yr Tsy Note

Treasury Yield Curve Source: Barclays Capital As of August 31, 2010

Source: Bloomberg Yield Spread between the 2yr and 10yr Tsy Notes

Market Returns Source: Barclays Capital As of August 31, 2010 Total Return 1 Yr 8/31/2010 Total Return 10 Yrs 8/31/10 (annualized) Aggregate Intermediate Agg Intermediate Gov/Credit Intermediate Credit Securitized High Yield S&P 500 Total Return

US Aggregate Year to Date Excess Returns Source: Barclays Capital As of August 31, 2010

What’s New? Liability Driven Investment (LDI)

Government Debt as a % of GDP

Selected Countries: Public Debt-to-GDP Ratio (In percent) Sources: United Kingdom: Goodhart (1999) and IMF, World Economic Outlook database. United States: Historical Statistics of the United States, Millennial Edition Online; Office of Management and Budget; and U.S. Census Bureau. Japan: Bank of Japan, Hundred-Year Statistics of the Japanese Economy; and Toyo Keizai Shinposa, Estimates of Long-Term Economic Statistics of Japan Since Data for Japan refer to the central government.

The Reality of Fixed Income Options “Let’s get real” Interest rates are near or at record lows depending on if we look at short term or long term rates. US GDP has been losing “velocity” for 50 years now. The US is in a second jobless recovery. 245 million Americans over the age of 16 with 80 million not working (for any reason). Source: US DOL, JKMAM

What Are the Market Options? Hey, rates stayed this low for 12 years between 1946 and It does happen. Whoa, rates can go lower with low inflation or continued dis-inflation. No one in this room lived with deflation and its consequences so we take the scenario off the table for investment purposes.

Snapple Cap Fact Interest rates can go negative, you pay someone to borrow your money. MARCH 26, 2009 US Treasury 1Month TBill -.005%

Fixed Income Options in Today’s Economy Investors have more options to DIVERSIFY style, process, and culture of their fixed income MANAGERS. A very unique period that does not have any leadership creates the opportunity to insert OPPORTUNISTIC strategies. That is, hire a manager on the pretense that they will be terminated upon success.

TAKE AWAY There is a need to find the optimal combination of NIMBLENESS and HIGH CONVICTION in the same investment process. That is to say, the “off the chart” low yields and high volatility need to be managed well or you will risk significant losses in bonds and fracture the manager.